RISK MANAGERS: A SEAT AT THE TABLE

April 7, 2010

Dr. Susan Mangiero, CEO of Investment Governance, Inc., discusses  fiduciary responsibilities and risk management with Mr. Karlheinz Muhr. Mr. Muhr is Chairman and CEO of Cenario Capital Management in New York, an independent asset and risk management firm for trusts, endowments, foundations, insurance companies, pension funds and family offices. Prior to forming Cenario, Mr. Muhr was Managing Director of Credit Suisse in the Asset Management Division and Head of Credit Suisse Volaris Volatility Management, based in New York, respectively.

Susan: Welcome, Karlheinz.

Karlheinz: Thank you very much, Susan.  Welcome everyone else as well.

Susan:  Let me start with a question about why a focus on risk management is needed and how this maps back to fiduciary responsibilities. Is there a particular galvanizing event that is causing more attention to be paid now to risk management than in the past?

Karlheinz:  The turmoil and turbulence we have seen in the markets in the last few years -- particularly over the past year-and-a-half -- probably could be called a galvanizing event.  But I think the whole approach to risk management and the changing role of the fiduciary has been in the making, in transformation for the last several years. I think it is a realization that people are starting to separate activities between what they would do with their own money and what they have to do as a fiduciary.  It is that re-definition of what it means to be a trustee of other peoples’ money. There we feel -- and I think we’re supported now by more and more people -- that there are principally two activities for which stewards should be held accountable. One is to avoid disastrous outcomes. Second, stewards must manage to meet an expected pay out rate, whatever that liability is, a bogey rate, a pay off rate that people are trying to achieve with a high degree of likelihood. Both of these aspects - avoid disastrous outcomes and manage toward an expected pay out rate - involve risk management. This is why I think we are seeing the subject matter front and center and clearly as a result of what has happened in the markets. 

Susan:  You talk a lot about fiduciary responsibilities with respect to risk management.  Do you feel that those functional and also explicit fiduciaries who do not pay attention to risk management are leaving themselves open to bad consequences?

Karlheinz: Absolutely, Susan. I think that once one accepts the notion that the prudent man rule is being re-defined by including hedging and risk activity, risk management clearly follows from that and people should be held to these higher standards.  Because when you think what’s really going on as a fiduciary, you are in essence the agent for the risk owner. The underlying risk owner is the pensioner.  He or she is the one who is expected to receive the scholarship and so on.  As a fiduciary, you are the agent for the underlying risk owner. Fiduciary obligations and the related legal risks are in fact rapidly rising here to the surface. It is not that people didn’t think they were prudent in the past.  Of course people are working very hard and I wouldn’t want to take anything away from people attempting to be careful. But when you see what has happened in the marketplace despite their good intentions, people have achieved disastrous results. Why is this? Because people have used strategies, assumptions that, once they were tested by the markets, didn’t hold up. If you use the principle of diversification, that’s fantastic and I wouldn’t want to take anything from Markowitz and others. But when you assume that correlations and asset allocations remain constant over time, the only thing you can do upfront is to set strategy and then let things ride through time, hoping you are not unlucky.  Mean-variance diversification is an erroneous assumption because you are not going to get good results in turbulent markets. We define turbulence as having two dimensions.  One is volatility. The other one is the breakdown of correlations.  What we have seen is that the breakdown of correlations has done great damage to portfolios and this is why the whole process and the activity of risk management should be, and has to be, intimately tied to the investment process.

Susan:  Let’s talk for a few moments about the different ways to measure and monitor risk.  There are many choices. Some of them are used more often than others - correlation for sure, standard deviation, value at risk and so forth.  Are there times when these measures are more applicable and what are some of the pitfalls with respect to relying on a single number?

Karlheinz:  First of all, relying on a single number would be as dangerous as owning just one single asset and thinking that might give you protection through time. I would encourage people to use a multi-dimensional approach.  The first issue to be considered is defining turbulence. Turbulence is not just defined by sigma and by standard deviations and volatility as such. It’s also defined by the breakdown, the unstableness, of correlations. One has to likewise examine implied correlations and then volatility.  An important caution against trying to achieve and measure your risk exposure is that your target rate is not an absolute thing. For example, it is not that foundations should be caught up in endowment envy because a particular endowment(s) had X return. Without an appropriate benchmark, a foundation or pension or any other investor is wasting time. You must know what to measure against. I strongly believe, and we help people try to understand, that an investment steward's obligation is towards the underlying constituency. Whether that constituency is a pensioner or that constituency is a university endowment administration, that retiree or college must get paid. People should be focusing on how to set up their portfolios in terms of goal-setting. Once you apply risk measurements against your portfolio and pre-specified target rate, performance can withstand the right scrutiny. In plain terms, if your bogey rate is 4 1/2 percent and that’s what you are suppose to achieve, everything below 4 1/2 percent is very bad news, right?  Returns might dip below the bogey rate for a quarter or half a year or a year, but to be significantly below that creates a massive short fund or gap. Conversely, as part of the same statement, everything above 4 1/2 percent is luxury.  Of course, we don't want to cap our upsides right at 4 3/4 percent or at 5 percent.  We understand we want to capture a bit more but one has to recognize that everything above the bogey rate is a luxury. Your principal obligation is to achieve the 4 1/2 percent and that’s not easy. What it means is that your only underlying asset, your own portfolio, is the present value of all future expected cash flows discounted at some appropriate rate. That’s what you own but you also own all future outcomes.  As an individual, you might say fine, I want to own all these outcomes.  I feel comfortable and can withstand variation. As a fiduciary, you cannot accept significant downside. You do not need to own and in fact cannot afford to own all outcomes. Some of outcomes might be luxuries that you want to own but you should instead probably sell into the market and take the chips off the table.  Some other outcomes are those to avoid at all costs. That’s what we call risk management.  This is why stress testing is important.  This is why scenario analysis is important. This is why understanding the skew and kurtosis of your current portfolio and your risk budget is important and so on.  That gives you a little bit of a framework as to the way we feel a fiduciary should go about decision-making. The point really is that these are not trivial manners.  They’re not that complicated, but some of them, some of these concepts are vastly counterintuitive.  Let me say one thing because people are knocking models and risk management. We’ve gone through the crisis and obviously some people have failed miserably. What we’ve gone through is not a Black Swan event. I’ve read the book and I know Nassim Taleb. He’s a very competent man but this was not a Black Swan event. This was an event that, just using regular turbulence scenario analyses, was included in the range of expected outcomes. People disregarded the obvious.  People can start pointing fingers and faulting themselves but recent market woes are not something that was a completely unexpected outcome.

Susan:  If I understand what you are saying correctly, we really need to look at some of the risk management oversight failures and learn that having a good process is really paramount. 

Karlheinz:  Yes and I think the process has to start from the top. It is a risk management culture that has to start permeating through the organization's structure and leadership. It is something that can't be viewed as an afterthought.  It cannot be viewed as risk control. There are many aspects to risk management. I’m talking about financial risk management. I’m talking about asset-liability risk management and other things. There is clearly reputational risk and other things that people have to integrate into a comprehensive program. At the end of the day, the two principal pillars of avoiding these disastrous outcomes and managing to an expected pay out rate are the two principal obligations that we feel belong exclusively to a fiduciary. These matters are not entirely trivial and, even if someone recognizes the importance of risk management, it can be very expensive to put it in place. Many endowments and pension funds feel that, if you are not at $15 billion or $20 billion, it doesn’t make sense to put a staff in place to do these things. We feel that there’s an open seat at the table. Besides the investment committee head, you have the investment consultants, the consultant community, the asset managers, the Wall Street firms. Then on the other side of the table, you have the internal CFO and CIO and the beneficiaries. You have a void with respect to the active and dynamic risk manager. Whether filling the seat will happen because of the immense pressures facing fiduciaries - via lawsuits and personal liability claims - remains to be seen. Risk management is an integral part of the overall investment process. Outsourcing the risk management function may be, at least for some organizations, the most cost effective way for people to address the void. Even large organizations with risk management teams are plagued if they succumb to group think. How is it otherwise possible that some very large banks took such big hits? They had all the tools. Many of these things that people started addressing when they ran their scenarios were probably washed under the table because groupthink took over.  So, having an arm's length risk management function, even at the large organizations, may become more prevalent going forward. Finance committee members as well as internal risk committee members will start looking towards outside firms to help them think through these strategies. 

Susan:  Karlheinz, you talk about a top-down approach and I couldn’t agree with you more. What happens, though, when you’re engaging with an institutional investor and maybe the chief investment officer is very supportive of a risk management approach but the board does not really encourage him or her to implement risk management? What happens if you don't have somebody at the top supporting this idea of a risk culture?

Karlheinz:  I think it’s a learning process, Susan.  And I think it’s unfortunately the people who are not getting up that learning curve who will ultimately be the ones who are most exposed from a legal and reputational standpoint. Even if ultimately it doesn’t mean that they have personal financial liabilities, they may lose their good name as trusted professionals. I cannot emphasize enough that a fiduciary adopts a sloppy process at great career risk and possibly much more. As an individual, you can do whatever you want to do with your investments. It doesn’t matter. It’s your money and you enhance it or you lose it. That’s one thing. But as a fiduciary you simply cannot afford to have an inadequate risk culture. There must be a broad-based understanding that risk management is necessary. This attitude has to be reflected by the investment committee members' decisions. It has to be reflected ultimately in every policy and procedure. It has to be implemented because otherwise it just remains talk. It just remains a theory and that’s where the outsourced risk manager comes in. He or she is given an explicit mandate to implement, let’s say, an avoidance strategy, a left-tailed risk management strategy, where you want to avoid outcomes that are more than 20 percent down in the market. Okay, well, that’s an explicit mandate that can be implemented actively and dynamically. That’s what I think is afoot here - this move towards risk management. While this paradigm is early in its adoption, I think it will really be accelerated. People are recognizing that you can’t just go back to business as usual after what we have witnessed. The market might be out for years to come. It will still be up fiduciaries to start implementing this risk understanding because ultimately they’ll be forced to do it if people don't do it voluntarily. That’s our belief.

Susan:  You’ve talked about the risk management process. You talked about outsourcing the risk management function.  A company like Cenario Capital gets involved at some or all stages of that risk management process. How does that logistically work or is that a function of each individual organization’s preference?

Karlheinz:  It is less a function of a fiduciary’s preference in our case because we don't tend to take on piecemeal mandates.  For us, it is a process and methodology that is transparent, repeatable and cost-effective. That’s what it ultimately has to be. It starts off with what we call the risk scan. This is basically an MRI of an institution's existing portfolio. Similar to when you visit a doctor and you take medical tests, this multi-fiduciary approach uses all of the best tools out there. Importantly however, results are only as good as the people who are interpreting the x-rays. The first part, the Cenario ScanTM, what we call the MRI, is important. It’s only the starting point. Then we work with the client to get a deeper understanding of what the liability structure of that endowment, that foundation, that insurance company’s portfolio looks like. This helps us to help the client to create a risk management approach that is tied to a target rate or other type of objective. That bogey rate is not the S&P 500. It is not Swensen’s Lazy Portfolio. It is your 4 1/2 percent or 3 3/4 percent that you are suppose to achieve in all-weather terms. Once we get to this point of establishing goals with the client, we can run models that "shock" the portfolio under different expected scenarios. We seek to separate "quiet," "transition" and "turbulent" outcome possibilities. Understanding turbulence is so important because turbulence in markets as well as in nature happens in serial order. Think about it this way. You hit the first bump in an airplane and you put on the seat belt sign. The reason why the captain asks you to put on a seat belt sign is because further bumps are expected. The market is the same way. We spend a lot of time, and that’s part of our process, to separate noise from signals once you hit the first bump. Once you get the first earthquake tremors, you have to tighten up the seat belts.  We argue that fiduciaries should be wearing seat belts all the time. It’s a question of degree as to how tightly you strap yourself in. This will be determined by the environment today and expectations about tomorrow. Thereafter, the action steps focus on implementation and execution. In that regard, we are a strong proponent of using the deepest, most liquid markets -- listed markets -- versus the over-the-counter ("OTC") market. It is our view that customized instruments are not the way to go, especially because there is often a constant need to rebalance hedges as market conditions change.

Susan:  Finally, I’d like ask you about the Cenario Risk Index. I know that you are about to start publishing this daily index through one of the big data vendors. Would you tell us more about what this index represents and why it could be helpful to institutional investors?

Karlheinz:  I’ll gladly go into that a little bit. The risk index that we have developed is a composition of five sub-indices and five sub-indicators. I’ll quickly tell you what they are.  We are looking at inputs of the equity option convexity, equity volatility, implied correlations, foreign exchange ("FX") volatility and credit spreads. Many of these indicators and sub-indicators are forward-looking. Options and futures are derived indicators. We feel that they provide a gauge that allows us to see what the propensity of risk is in the market, the risk appetite if you will. The red graph on the chart indicates the Cenario Risk Index ("CRI"). The SPX, the broad-based U.S. market indicator, is shown in blue. When you have spread CRI compression, it’s almost like winding up a spring. It gives you an indication that people have great propensity to put on risk. This spring ultimately unwinds and then explodes. We are using it obviously as a tool to separate signals from noise. I’m not saying this is a crystal ball. This is not a predictive tool that works and you just blindly apply it.  The CRI gives you an indication of the risk preference across markets. This is only one of the dimensions. The CRI has four other parts to it and in that sense has become an extremely effective tool for us to use as a gauge - a warning signal - for people to recognize a red alert. The index is based not on absolute numbers, but on standard deviation moves. When you look at the index here, on the left hand of the scale, it goes from minus two standard deviations off the main to plus six. There was a six standard deviation move in October and November of 2008. Right now what we see here is that we have tremendous spread compression.  We see volatility dropping dramatically.  We have credit spreads coming down. That the complacency has really re-entered the marketplace, and for us dropping below the zero mark, suggests that we are moving into the danger zone again. In order to help our clients, we have started to publish a number of new predictive strategies in the last few days. We feel that the CRI is really now moving into the danger zone in multiple markets.  The CRI levels indicate that people have kind of thrown caution to the wind and that we might be setting ourselves up for another rocky period here.

Susan:  This is quite interesting.  All of the information you presented today is tremendously helpful as we embrace a new paradigm, away from a return focus to very much of a risk focus. As I’ve said many times, we are all risk managers now. Is there anything you’d like to leave the audiences with in terms of let’s say the next several things that people should do immediately in terms of risk management action?

Karlheinz:  Well, I’d like to go back to what I said initially.  I think the sheer recognition that there is quite a dramatic shift in the role of the fiduciary should grab people's attention. The world has really changed and people are being held accountable. There have been multiple lawsuits directly addressed at directors. The CEO has to sign the financial statements and so forth and so on. I don't know how far along we are in the process, how quickly some of this will work its way through Congress and be entered into law, but I wouldn’t wait for that. So, what I would like to urge is that listeners consider the changing role of the fiduciary and quickly adapt to integrating hedging as a basic principle, an ongoing principle to guides the investment process. I think it is not just a question of quickly slapping on a trade, a bond, a structured note or whatever. That’s not the answer. I think one has to do the hard work. It has to be done with top-down support and bottom-up "heavy lifting."  I think it should be done, should start with the process of conducting a broad-based risk analysis, identifying where the risks are buried to come up with a risk budgeting process. For example, we work with endowments, many of which rely on the 60-30-10 rule or 60-40. But when people find out that 90 percent of their risk is buried in the 60 percent equity, it is a big wake-up call.  Because people thought they were balanced, broadly allocated and protected. Lo and behold, it turns out that you can tell them ahead of time. You don't have to wait for the market to shock the portfolio to understand that 90 percent of the risk is embedded in the 60 percent. That is something that people have to start internalizing, recognizing, and then addressing.  I think the underlying constituency will be better off, the more broadly these thinking processes and ultimately, related strategies, will be deployed. That’s all we can hope for because we don't do these things just ourselves. We’re doing it for the benefit of others - the true risk owners.  All the fiduciary really does is serve as an agent of the underlying risk owner. 

Susan: This is food for thought for sure.  Thank you so much for your time today and we’ll look forward to speaking with you again.